Ron Keith, Riverwood Solutions Electronics Production | June 18, 2009
The Changing EMS Landscape - Over the next 5 years
The 20th century Austrian economist Joseph Schumpeter popularized the term “Creative Destruction” in part to explain the wave of economic cycles that persist in the socioeconomic system of capitalism.
The Changing EMS Landscape - Part 2 of 3, Over the next 5 years By Ron Keith, Chief Operating Officer, Riverwood Solutions Over the past 18 months, the world and particularly the EMS industry has been experiencing what is probably the greatest cyclical downturn in modern economic history in terms of the overall destruction of wealth. Some estimates put the loss of global wealth in the current recession as high as $25 trillion, which seems a reasonable figure considering that the total wealth of U.S. households has declined from $64.4 trillion to $50.4 trillion over the past six quarters. The total market value of publically traded EMS companies over the same period has faired far worse, losing almost 70% since the start of the downturn. There can be little doubt as to the amount of economic destruction that has occurred in the EMS industry in this recession. But the very abrupt decline in the value of EMS companies that happened last fall was just another leg down in a secular trend that is now almost a decade long. One proxy measure of EMS companies’ market value (the combined market cap of the top three North American EMS companies) peaked in late 2000 at about $51B, hit bottom in March 2009 just below $2B, and currently stands at about $5.2B. This represents a 90% decline in market value for an industry proxy that has seen revenues more than triple over the same period of time, suggesting that the value to an EMS company of a 2009 revenue dollar is less than 3% of the value of a 2000 revenue dollar in terms of shareholder value. The destruction in the average value of revenue that has accrued to the purveyors of electronics manufacturing services is well known in the industry, among EMS customers, and across the financial community. Will this destruction within the EMS industry prove to be a natural part of Schumpeter’s “Creative Destruction” within the framework of an EMS industry as we know it today, or will the future look completely and unrecognizably different than what we see today? As we seek to answer this question, bear in mind that all EMS companies have numerous stakeholders including owners, employees, customers, and suppliers. Given that all companies, public and private, are created to enhance the wealth of the company’s owners, and given the fact that the EMS industry has done nothing but reduce the wealth of its business owners for nearly a decade, this author firmly believes that the major changes in the EMS industry over the next five years will be highly focused on creating value for the owners and shareholders of the EMS companies. Consider Dr. Schumpeter’s thoughts on the causes of, and responses to economic cycles by capitalist enterprises: “The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates……. …….. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in… …Every piece of business strategy acquires its true significance only against the background of [this] process.” Joseph Schumpeter, 1942 So what strategic responses to this destruction are we likely to see from EMS players and when? Is the industry on the cusp of major strategic and structural changes today or will the catalysts for change be more slow in coming? Will these changes be driven by boards of directors trying to appease shareholders or by bankruptcy judges trying to apportion the remains of failed strategies? If I truly knew the answers to any of these questions I would be far too preoccupied with untold wealth to spend my time opining about the future of the EMS industry. But, as both a long time participant in the EMS industry and a lifelong student of the complex enterprise of business, I believe that I am as well positioned as any to foretell the future and paint a picture of the changing landscape of the EMS Industry. A Less Brave – and Slightly Smarter New World The EMS industry in recent history has been a fairly acquisitive group, acquiring literally thousands of companies and asset pools to expand capabilities, geographies, or simply to expand their top lines. As the primary currencies for EMS acquisitions (the various companies’ stocks) have devalued over the past few years faster than a 1998 Russian Ruble, the pace of major acquisitions has slowed to a crawl. Especially hard hit by the generally reduced level of EMS acquisitions have been the various Western OEMs that have sought to divest themselves of legacy manufacturing assets in favor of a leaner outsourced model that provides for improved asset efficiencies. In recent months several OEMs have floated trial balloons on divesting various manufacturing assets to some of the top EMS players with generally mixed to unfavorable responses. Mostly gone are the days when virtually any OEM could goose its balance sheet simply by calling up Lehman Brothers or Goldman Sachs and divesting their inefficient, poorly located manufacturing assets with huge legacy costs in a fiercely competitive bidding process between major EMS providers. Despite the best efforts of the remnants of investment banks to put some lipstick on a few pigs, the majority of EMS players remain wary of OEM asset purchases unless the long term economics are extremely sound. Contractual assurances from divesting OEMs, no matter how airtight, have little ability to modify the competitive landscape or fundamentally alter the immutable laws of economics. OEM manufacturing assets that lack geographical competitiveness are unlikely to be purchased by the most financially sound EMS players unless they either: (a) provide access to some highly valuable process technologies, or; (b) are financially structured such that the front end of the transaction sufficiently compensates the EMS provider with an adequate return on the investment after all of the various potential costs and liabilities are considered. This is not to say that some desperate OEMs may not divest assets to some even more desperate EMS providers, or that no OEMs will make deals where they have sweetened the pot sufficiently to allow an appropriate return to an EMS asset buyer. But the days of the OEM business land-grab via wholesale factory divestures has come to end. Also gone are the days of big technology based acquisitions by EMS providers using their stock as currency. Although a number of these purchases have been very successful for the EMS players, the vast majority of purchases have failed to live up to expectations in terms of driving incremental revenue and profit margin expansion. In fact, technology related acquisitions have been one of the greatest destroyers of shareholder value for EMS companies, creating not only various cash charges adversely impacting earnings, but also creating massive non-cash goodwill write-offs that have suppressed share prices – especially when additional shares were issued by the EMS provider as transaction currency. Looking at the retained earnings on the balance sheets of the top five publicly traded North American EMS providers reveals a cumulative retained earnings figure of a staggering -$14B. Roughly 80% of these negative earnings were driven by non-cash write-offs of goodwill associated with various competitive EMS and technology acquisitions. This is not to throw stones at the EMS companies that have undertaken these acquisitions, as I myself made a few very poor acquisitions as an EMS executive. The point here is simply that the real costs and the real benefits of many of these types of acquisitions take several years to determine, and in general the track record has been such that technology based acquisitions will slow considerably for the EMS industry going forward. The types of acquisitions that will likely dominate the EMS industry for the next five years are industry consolidating acquisitions. Most of these transactions will be among smaller tier three and tier four players who merge with or acquire competing businesses that are complementary and possess very low levels of asset redundancy. But there will also be a few larger EMS industry hook-ups as tier two players seek to increase their scale-based competitiveness. The EMS Industry’s Fight to Enhance Shareholder Value The evolution of the EMS industry has been fascinating to watch over the past decade or so, and no doubt will be equally fascinating over the coming decade. Companies like Solectron and SCI, who cumulatively occupied the number one position in the industry for well over half of the EMS industry’s history, have both gone the way of the Dodo bird, being fully devoured by faster moving competitors (see Figure 1 below). Once promising companies like MSL, EFTC, Xetel, and hundreds of others were marked for extinction – not by a meteor induced cataclysm, but by a combination of strategy and business choices that left them unable to compete for the ultimate resource: customers. Figure 1: Survival of the fittest and fastest - the top 5 EMS providers circa 1998 As the financial meltdown of 2008 has given way to the more controlled contraction of 2009, many EMS providers – especially in Europe – face the prospect of near term extinction. Excessive leverage, excessive customer concentration, and excessive manufacturing capacity in all the wrong places will considerably thin the EMS pack over the next six to eight quarters. Many tier two and tier three EMS providers pursuing a generalist strategy are finding themselves trapped between smaller, more nimble, more narrowly focused specialty providers and the tier one purchasing power giants with whom they cannot compete on materials procurement which accounts for more than 85% of total costs. For a number of these companies, neither Darwinian mutation nor the more purposeful strategic adaptation proposed by Organizational Ecologists such as Glenn Carroll can do much to save these companies. The die has been cast and the issue is now a matter of how and when the end will come for many mid-market EMS players – not if it will come. For many of the EMS companies in the middle that have made better strategic decisions (and also for those that have been just plain luckier), the desire to have a future most likely necessitates a significant change in strategic direction as the industry matures and the rate of growth declines. The rapid growth, maturation, and consolidation of various industries has been observed and well documented since the industrial revolution, and the basic pattern of history will not likely differ for the EMS industry. Prior to the global recession of 1921, there were more than 1,500 automobile manufacturers in the U.S. and more than half as many in Europe. By 1933, more than 80% of those companies were no longer in existence. Those companies that remained could easily be grouped into three basic categories: 1) Small specialist or niche players such as Willy’s (Jeep) and Aston Martin; 2) Larger generalists such as Daimler and Ford; 3) Hundreds of manufactures in the middle destined for oblivion. Over the following 25 years, another 80% of the automakers in the U.S. and Europe disappeared and even more would have been subjected to failure if economics had been allowed to be the sole deciding factor of corporate fate. The global EMS industry will likely suffer a somewhat similar fate, although the nature of service businesses is such that they are not subjected to quite the same ecological forces as product companies. What will the EMS industry of 2015 look like? - It will likely be dominated by just three massive global players, as seems to be the general case with a great many mature industries. - Niche players will continue to flourish, and in fact will likely expand their market share vs. the largest global players. - Technical/market specialization, narrow focus and enhanced customer service will continue to drive more and more OEM companies to seek solutions outside of the few remaining tier one providers as many middle market players continue to disappear. - The very large multinational and supranational OEMs will continue to utilize the top tier EMS providers, all of which will likely have revenues in excess of $75B. - These tier one providers will serve a more limited customer group than at present, opting to focus their attention and resources on a select group of 50 to 100 customers where their economies of scale are more likely to be realized economically. Both the EMS providers and their OEM customers will come to realize that in many cases, the economies of scale and fixed asset leverage enjoyed by the largest EMS companies are never fully realized by their smaller outsourced OEM customers for a number of different reasons. Absent the ability to realize extremely compelling prices from one of the EMS purchasing power giants, many of the small and mid-sized OEMs will seek the higher level of service they anticipate getting from smaller niche players. This bifurcation of the EMS industry and the hollowing out of the middle tier is very common in many industries and is well described by a number of academic theories. As the top EMS companies have grown larger, they have employed the advantage of scale not only to lower costs, but also to expand the depth and breadth of their service offering into new market segments. Maintaining high growth rates against an ever expanding denominator of revenue has driven the top tier to reach into numerous related businesses. To both quote and loosely paraphrase Glenn Carroll: Over time “these successful organizations become generalists in that they serve diverse markets and perhaps rely on diverse capabilities and grow large.” As more and more of the small generalists fail due to their lack of ability to competitively secure a wide range of resources (components, financing, managerial talent, etc.) their target markets become more free to competition. The viability, competitiveness, and market share of specialists often increases when an industry becomes more concentrated at the top. Thus, as an industry becomes dominated by large generalists, these large companies often inadvertently set “the stage for the entry and success of small and highly specialized firms.” In Part 3 of this article series, we will explore the EMS industry of 2015 in more detail, discussing issues including specialization, in-sourcing, vertical integration, sum-of-the-parts valuation models, near-shoring, and controversial views on the future role of the ODM. www.rwsops.com
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